9: Capital Budgeting Process and Decision CriteriaQUESTIONS
Q9-1 Can you name some industries where the
payback period is unavoidably long?
Q9-2 In statistics, you learn about Type I and Type II
errors. A Type I error occurs when a statistical
test rejects a hypothesis when the hypothesis
is actually true. A Type II error occurs when a
test fails to reject a hypothesis that is actually
false. We can apply this type of thinking to
capital budgeting. A Type I error occurs when
a company rejects an investment project that
would actually enhance shareholder wealth.
A Type II error occurs when a company
accepts a value-decreasing investment, which
should have been rejected.
a Describe the features of the payback
rule that could lead to Type I errors.
b Describe the features of the payback
rule that could lead to Type II errors.
c Which error do you think is more likely
to occur when companies use payback
analysis? Does your answer depend on
the length of the cutoff payback period?
You can assume a ‘typical’ project cash
flow stream, meaning that most cash
outflows occur in the early years of a
project.
Q9-3 Holding the cutoff period fixed, which method
has a more severe bias against long-lived
projects, payback or discounted payback?
Q9-4 For a company that uses the NPV rule to make
investment decisions, what consequences
result if the company misestimates
shareholders’ required returns and consistently
applies a discount rate that is ‘too high’?
Q9-5 ‘Cash flow projections more than a few
years out are not worth the paper they’re
written on. Therefore, using payback
analysis, which ignores long-term cash
flows, is more reasonable than making
wild guesses, as one has to do in the NPV
approach.’ Respond to this comment.
Q9-6 ‘Smart analysts can massage the numbers
in NPV analysis to make any project’s NPV
look positive. It is better to use a simpler
approach, such as payback or accounting
rate of return, that gives analysts fewer
degrees of freedom to manipulate the
numbers.’ Respond to this comment.
Q9-7 In what way is the NPV consistent with the
principle of shareholder wealth maximisation?
What happens to the value of a company
if a positive NPV project is accepted? If a
negative NPV project is accepted?Q9-8 A particular company’s shareholders
demand v a 10% return on their investment,
given the company’s risk. However, this
company has historically generated returns
in excess of shareholder expectations,
with an average return on its portfolio of
investments of 20%.
a Looking back, what kind of share-price
performance would you expect to see
for this company?
b A new investment opportunity arises,
and the company’s financial analysts
estimate that the project’s return will
be 15%. The CEO wants to reject the
project because it would lower the
company’s average return and therefore
lower the company’s share price. How
do you respond?
Q9-9 What are the potential faults in using the
IRR as a capital budgeting technique?
Given these faults, why is this technique so
popular among corporate managers?Q9-10 Why is the NPV considered to be
theoretically superior to all other capital
budgeting techniques? Reconcile this
result with the prevalence of the use of
IRR in practice. How would you respond to
your CFO if she instructed you to use the
IRR technique to make capital budgeting
decisions on projects with cash flow
streams that alternate between inflows and
outflows?Q9-11 Outline the differences between NPV,
IRR and PI. What are the advantages and
disadvantages of each technique? Do
they agree with regard to simple accept or
reject decisions?Q9-12 Under what circumstances will the NPV,
IRR and PI techniques provide different
capital budgeting decisions? What are the
underlying causes of the differences often
found in the ranking of mutually exclusive
projects using NPV and IRR?